Sustainable Finance Disclosure Regulation for funds: key reporting requirements and practical tips for investment funds under the SFDR
The Sustainable Finance Disclosure Regulation (SFDR) and its Regulatory Technical Standards (RTS) imposes several types of reporting requirements that investment funds are expected to comply with. With the reporting deadline swiftly approaching, SFDR reporting for investment funds has undoubtedly become a source of frustration for asset managers. While many aspects of the reporting obligations are yet to be clarified by the EU, investment funds are expected to provide quite extensive disclosures already in 2023. In order to provide transparent and accurate disclosures and comply with the regulatory requirements, asset managers will have to overcome numerous challenges such as low availability of the data required, poor quality of the data obtained from their portfolio companies, and unclear interpretation of the applicable regulation (SFDR and RTS).
The following article sheds light on the different types of reporting requirements prescribed by the SFDR and how to practically approach them from an investment fund perspective. It also provides guidance on how to ensure compliance with the regulatory requirements, achieve best practices under the reporting process, and set yourself up for success in the upcoming reference periods.
What does the SFDR mean for investment funds?
The SFDR represents one of the main EU's tools to increase sustainability-related transparency of financial markets by establishing comprehensive reporting requirements regarding environmental, social, and governance (ESG) aspects. The SFDR was first introduced as a key component of the EU's Sustainable Finance Action Plan in 2019, alongside the EU taxonomy regulation. Despite the fact that the SFDR and the EU taxonomy Regulation are two separate elements of the EU's Sustainable Finance Action Plan, they are interrelated. You can find out more about the relationship between the SFDR and the EU taxonomy in our separate article.
The main aim of SFDR reporting for investment funds is to provide a comprehensive framework to capture ESG performance of investment funds and other financial market participants. The framework should enable investors to make informed choices regarding the environmental and social impacts of their investment decisions, direct capital towards sustainable activities, and prevent greenwashing of financial products. With investors paying increasing attention to the ESG aspects and impacts of their investments, it will be crucial for investment funds to successfully tackle the reporting requirements imposed by the SFDR.
It is important to keep in mind that the goal of the reporting is to provide transparent and accurate data of the fund's performance in accordance with the SFDR, not to achieve a certain level of sustainability performance. However, the long-term vision of the regulation is to encourage financial market participants to improve their ESG performance, to direct their investments towards more sustainable activities, to reduce investments into environmentally and socially controversial activities, and to enable funds with an ESG focus to highlight their performance and positive impact.
Why do investment funds need an SFDR report?
What is the reporting obligation based on?
The legal obligation to report under the SFDR is based on the status of a financial market participant, as outlined in the SFDR itself and applies to financial market participants whose products are marketed in the EU. Financial market participants are understood as all entities offering financial products where they manage clients’ money. The SFDR provides a list of financial market participants in its Article 2(1) that includes entities such as institutional investors, insurance companies, pension funds, and of course, asset managers.
What is (and isn't) required from investment funds under the SFDR?
As previously mentioned, the main requirement under the SFDR for investment funds is to provide transparent and accurate data regarding the fund's ESG performance. Therefore, a fund report under the SFDR needs to provide the correct disclosures based on the fund's classification. And while the reporting burden differs depending on how funds choose to classify themselves, compliance is based on the reporting performance, not on achieving a certain level of sustainability per se. To put it simply, you will not be penalized for not being sustainable as long as you provide transparent data documenting your performance.
The extent of the reporting is based on the fund's classification. The SFDR distinguishes different levels of disclosure requirements based on the extent to which the fund considers sustainability risks, whether it promotes environmental and social characteristics, and whether the fund has a sustainable investment objective. Consequently, all investment funds qualify for one of the three categories outlined under the SFDR:
Article 6 category - includes funds that do not promote ESG characteristics and do not integrate sustainability into their investment processes.
Article 8 category (also known as “light green”) - includes funds that promote environmental and social characteristics but do not have a sustainable investment objective.
Article 9 category (also known as “dark green”) - includes funds that have a sustainable investment objective and are expected to target sustainable investments.
Investment funds are free to decide which category they want to be labeled as based on their ESG ambitions provided that they can comply with the reporting criteria set for the chosen category. The following section will address how the specific disclosure requirements differ for Article 6, 8, and 9 funds.
What are the benefits of SFDR reporting for investment funds?
Being a frontrunner in ESG reporting under the SFDR brings about a number of benefits for asset managers that choose to approach the requirements proactively and with ambition. Not only will the reporting under SFDR enable you to highlight your unique ESG performance, it will also make your performance more comparable to other players on the financial market. Performing well might do wonders for your marketing strategies and increase the trustworthiness of your fund in the public eye.
While most investment funds will struggle gathering the data during the first reference period, the reporting process is expected to become much faster and smoother in the upcoming years. The data obtained will allow you to measure your ESG progress and further assist you while formulating and adjusting your future investment strategies and internal policies.
You can find out more about what is sustainable finance and what benefits it brings on our blog.
What about enforcement?
When it comes to the enforcement of SFDR reporting for investment funds, the consequences for failing to comply with the reporting requirements are twofold. Firstly, providing incomplete or even false data regarding the funds's ESG performance would considerably endanger the fund's reputation and would prevent sustainability conscious investors and clients from allocating their money into funds that failed to meet the disclosure criteria.
Secondly, the legal consequences of non-compliance will be handled on the EU member state level by national law and for the many member states will entail financial penalties based on the fund's net turnover.
As a reaction, an increased occurrence of “green-bleaching” has been observed across the EU financial markets. This means that many investment funds decide not to report any ESG characteristics in order to avoid having to comply with the rules set for Article 8 and 9 funds and the legal risks associated with those. The Securities and Markets Stakeholder Group advises that more specific regulatory guidance from the European Supervisory Authorities will be required to tackle this issue.
SFDR reporting requirements for funds
SFDR reporting requirements for Article 6 Funds
Website disclosures for Article 6 Funds
The Article 3 of the SFDR requires a website disclosure on the fund's policies on the integration of sustainability risks in their investment decision-making process. This means that Article 6 funds without an ESG scope that do not consider adverse impacts of investment decisions on sustainability factors need to state that they do not consider them. Further they need to provide the reasons why those are not relevant to their fund, accompanied by information on whether they intend to include them into their policies in the future. This information needs to be published in a separate section titled “No consideration of sustainability adverse impacts''. This concept is commonly known as the “comply or explain” approach.
Product level disclosures for Article 6 Funds
According to the Article 6 of the SFDR, financial market participants need to explain how sustainability risks are integrated into their investment decisions and publish the results of the assessment of the likely impacts of sustainability risks on the returns of their financial products in their pre-contractual disclosures.
Similar to the website disclosures, if the fund considers sustainability risks not to be relevant they need to provide an explanation why. Where sustainability risks are deemed relevant, the funds must report how those risks are assessed and implemented into their policies.
This is in line with the “double materiality” concept engrained in the SFDR. This means that the investment fund needs to provide information both on how the fund itself is affected by sustainability risks but also how their investment decisions impact society and the environment.
SFDR reporting requirements for Article 8 Funds
Website disclosures for Article 8 Funds
Website disclosure requirements for funds promoting environmental and social characteristics are specified in articles 24 - 36 of the RTS. The reporting requirements are more extensive compared to what is required from Article 6 funds. The RTS provides quite detailed guidance on what sections need to be included, such as the description of the environmental and social characteristics of the fund, the fund's investment strategy, the investment proportion, their monitoring practices, methodologies, data sources, engagement policies, and reference benchmarks.
Pre-contractual and periodic disclosures for Article 8 Funds
Article 8 funds are obliged to publish pre-contractual and periodic disclosures. Those are correlated, and the main point is for funds to state their minimum ambitions in the pre-contractual disclosures and subsequently report on their achievements in the given reference period in the periodic disclosures which are to be updated on an annual basis. The content and the structure of the disclosures are prescribed by the Templates in Annexes II (pre-contractual) and IV (periodic) to the RTS. The Templates require following information to be provided by Article 8 funds:
- Description of the fund's environmental and social characteristics (including relevant sustainability indicators to measure performance and environmental and social objectives the investments intends to contribute/contributed to)
- Statement whether the product intends to make/made any sustainable investments
- List of largest investments
- Visualization of sustainability-related and other investments intended to be made/made by the product
- Disclosure on the taxonomy alignment of the fund's investments
- Relevant reference benchmarks to measure the fund's performance compared to the market average
SFDR reporting requirements for Article 9 Funds
Website disclosures for Article 9 funds
Website disclosure requirements for funds that have a sustainable investment objective are outlined in articles 37 - 49 of the RTS. The reporting requirements are again more extensive compared to Article 6 funds and more sections need to be included on top of what is already required for Article 8 funds. The additional sections for Article 9 funds include the explanation how the investments of the financial product do not significantly harm any of the sustainable investment objectives, description of the sustainable investment objective and how it's attained.
Pre-contractual and periodic disclosures for Article 9 funds
Similar to Article 8 funds, Article 9 funds need to publish both pre-contractual and periodic disclosures. Those should again follow the structure prescribed by the Templates contained in the Annexes III (pre-contractual) and V (periodic) to the RTS. The mandatory sections prescribed by the templates are following:
- Description of the sustainable investment objective of the fund (including the environmental and social objectives the investments contributed to, explanation how the investments cause no significant harm to the objective, consideration of Principal Adverse Impact indicators)
- List of largest investments
- Visualization of sustainability-related and not-sustainable investments intended to be made/made by the product
- Disclosure on the taxonomy alignment of the fund's investments
- Relevant reference benchmarks to measure the fund's performance compared to the market average
The main difference between the reporting requirements for Article 8 and 9 funds is that Article 9 are expected to target sustainable investments. Consequently, in order to meet the criteria of the “sustainable investment” definition set in the Article 2(17) of the SFDR, the fund needs to prove that the sustainable investments cause no significant harm (DNSH) to environmental and social objectives. In order to fulfill the DNSH criteria, the product disclosures must include a full consideration of all mandatory Principal Adverse Impact indicators (PAI indicators) listed in the Annex I to the RTS and any relevant additional environmental PAIs from Table 2 and social PAIs from Table 3 of the Annex I to the RTS.
What are PAIs?
The PAI indicators are a list of factors designed to measure the sustainability performance of a fund's portfolio and cover a wide range of environmental and social issues such as GHG emissions, energy consumption, effects on biodiversity, generation of waste, and compliance with international human rights instruments. As a general rule, a PAI consideration requires financial market participants to disclose their performance on 14 mandatory PAI indicators from Table 1 of the Annex I to the RTS and at least one additional environmental indicator from Table 2 and one additional social indicator from Table 3. On top of that, investment firms and their portfolio companies are free to define their own custom indicators to highlight their performance in areas not covered by the regulation.
In order to correctly report on those, investment funds need to collect all the required information from their portfolio companies. The mandatory disclosure on PAI indicators has been one of the most disputed issues imposed by the SFDR requirements. The PAI data is seldom available and multiple branches of a portfolio company need to contribute to the time-demanding data collection process in order to cover the full scope of factors required by the mandatory PAI indicators. Under the reporting on the first reference period 2022, this seems to be the most burning issue for SMEs and young companies that simply lack the personnel and capacity to undertake the data collection and reporting process.
In April 2023, the ESA's published a Joint Consultation Paper that contains an updated draft of the RTS and suggests simplified versions of the pre-contractual and periodic disclosures. However, the Consultation Paper is now open to suggestion and a final version of the draft will not be available until the fall of 2023. But it can be reasonably expected that the contents of the templates will be updated before the 2024 reporting deadline.
What about taxonomy reporting under the SFDR?
The EU taxonomy is a framework of classification criteria that identifies environmentally sustainable economic activities and is governed by the Taxonomy Regulation. An investment is considered Taxonomy-aligned if it invests into an activity that is eligible under the Taxonomy and that further meets the technical screening criteria. Read more about the importance of accurate EU taxonomy alignment on our blog.
Article 8 and 9 funds need to report on taxonomy-alignment of their sustainable investments. Firstly, they need to do so in the pre-contractual disclosures by stating their minimum share of taxonomy-aligned investments. Secondly, they need to calculate and report the actual share of their taxonomy-aligned investments in their periodic disclosures. To find out more, please see our article on how to report on the EU taxonomy as an investment fund.
Tips for funds to create a better SFDR report
Accurately label your financial product
Investment funds will first need to undertake a formal process to review, assess and categorize all their financial products into the Article 6, 8, or 9 categories. To accurately assess what the label of your product should be, product teams and portfolio managers should contribute to the review process. The outcome of the review process will determine the positioning of your fund on the market and will considerably influence your future investment policies.
Follow a step-by-step guidance for the population of product level disclosures
- Identify the information you need to obtain for the fund report under the SFDR.
- Distinguish data that is publicly available, data you have already collected from your portfolio companies, data made available by a third-party service (for example the Taxonomy alignment of your investments from Celsia), and data yet to be obtained from your portfolio companies.
- Adopt procedures to gather and review all missing data required by the mandatory disclosures, reach out to your portfolio companies with requests for data.
- The periodic templates should be considered together with your pre-contractual templates to ensure a unified approach (link the numbers generated and how pre-contractual layout commitments connect to the periodic report on actual achievements).
- Populate and publish periodic templates as a part of your annual report by the 30th of June.
- Compare the commitments set in the pre-contractual disclosures and the actual achievements of the financial product in the periodic disclosures. (According to ESMA, the periodic disclosures are intended to appropriately reflect the Taxonomy-aligned investments achieved by the product, including where the actual Taxonomy-alignment is higher than the minimum proportion. So, while the periodic disclosures should be in line with the pre-contractual commitments, the periodic disclosures must calculate the shares of different categories of investments based on the data gathered during the reporting period, even if those exceed the commitments made in the pre-contractual disclosures. For example, if you stated a 0% share of taxonomy aligned investments in the pre-contractual disclosure you still need to calculate the actual share of investments into taxonomy-aligned activities in case the product has made any.)
- Remember to update your pre-contractual disclosures based on the actual numbers published in the periodic disclosures to ensure future alignment.
Additional practical tips based on Celsia's experience
- Set a realistic timeline to gather data from your portfolio companies and keep in mind that the first reporting period is more time-demanding and labor-intensive and the process will become much faster in the upcoming years
- Expect that data availability and data quality from your portfolio companies in the first reference period might be low and consider a third-party service to assist your portfolio companies with the data collection
- Keep in mind the alignment of pre-contractual and periodic disclosures
- Use the challenges you come across during the data collection process in the first reference period to formulate policies and procedures to make the reporting process more efficient in the upcoming reference periods
- Use the requirements set by the SFDR, the RTS, and the EU taxonomy to suggest policy improvements to your portfolio companies that will help them achieve higher Taxonomy-alignment and help you improve your PAI performance
How Can Celsia be Useful to You?
Celsia keeps you up to date with the ever-changing regulations on sustainability reporting and helps you navigate through SFDR and EU taxonomy reporting. Through the following steps, the Celsia scoring software for the EU taxonomy lets investment firms configure their SFDR reporting, collect data from their portfolio companies:
1. Select the appropriate PAI indicators for your portfolio (Celsia & investor)
2. Screen portfolio companies for eligibility with the EU taxonomy (Celsia & investor)
3. Match companies with relevant EU taxonomy activity (Celsia & portfolio company)
4. Upload data on PAI indicators and EU taxonomy performance (portfolio company)
5. Aggregate fund results (Celsia)
6. Report results on website and in periodic disclosures (Celsia)
The SFDR brings about a new set of rules and requirements that investment funds need to comply with and the first reporting period has proven to be challenging for both investment funds and their portfolio companies. However, undertaking the reporting procedure is a unique opportunity to highlight the fund's ESG performance and gather valuable insights on how to improve the fund's sustainability impacts. Moreover, the reporting requirements under the SFDR encourage investment firms to evaluate and fortify their ESG policies which also positively influences the sustainability-related efforts of their portfolio companies.
Successfully meeting the reporting criteria outlined under the SFDR and the RTS will entail gathering a considerable amount of data that many asset managers have never reported on before. However, the information that will be made publicly available based on the regulatory requirements will significantly help to prevent green-washing and ESG cherry-picking on the financial markets and will allow competitors to comprehensively compare their ESG performances. On top of that, the results generated by the reporting process will provide valuable guidance for investment funds to create more sustainable future investment strategies.
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